Option trading basics teaches us that selling call and put options is actually selling time value. Time value consists mainly of time to expiration stats and the implied volatility (IV) of the underlying security. Since most of us are selling monthly options, the main distinguishing factor in our option prices is the implied volatility…we are selling volatility.
In this article we will take a look at how implied volatility is impacted by individual stock events and then we will take a broader look as to how implied volatility is influenced by supply and demand for options based on market perception.
Individual stocks
There are certain events that can cause the market to anticipate a significant price change in our stocks and exchange-traded funds (ETFs) and therefore elevate the implied volatility of the associated options. The most common of these circumstances are earnings reports, a topic I will never stop discussing because I consider it so important to our ultimate success. Other events, like impending FDA announcements of drug approvals and Federal Reserve announcements (among others) will also elevate implied volatility and therefore our option prices. However, higher IV also means greater risk as share value can decline significantly thereby resulting in substantial losses. This is why a BCI golden rule is to never sell a covered call or put option when there is an upcoming earnings report prior to expiration Friday. Although IV is influenced by a myriad of factors, earnings reports are one of the most common and important as shown in the chart below highlighting the volume spikes (as shown by the CBOE Volatility Index or VIX) in each of the last 4 earnings quarters:
Implied volatility and earnings seasons
General market perception
Options are used for three major reasons:
- Generating cash flow (that’s us!)
- Speculation (betting a stock price will move up or down)
- As a risk management tool (hedging)
Hedging
Institutional investors (mutual funds, hedge funds, banks and insurance companies) use options to protect their multi-million dollar portfolios. When there is an impression that risk is increasing, there is a greater demand for option hedging (buying puts as an example) and as a result prices of these securities will rise. On the other end of the spectrum, when the market is presuming a period of lower volatility the demand for option protection is lessened and therefore options are sold and prices decline.
Speculation
There is a greater demand for call options as IV increases because shares of stock can be controlled at a much lower cost and if the trade turns against them, there is less capital risk than if the shares had been purchased. In addition to this, during times of low volatility, speculators will turn to selling options (just like us) to elevate the returns they are not receiving due to the low-implied volatility environment.
Summary
Long option positions are supported by high volatility conditions while short option positions benefit from low volatility situations. Buying and selling options is equivalent to buying and selling volatility.
Next live seminar (click on city for more information)
Friday, November 21st
Market tone
This week’s data was mixed but still re-enforcing the continued expansion of our economy:
- The unemployment rate for October dropped for the 3rd consecutive month to 5.8%
- According to the Labor Department 214,000 non-farm payroll jobs were added but below the 231,000 projected
- The ISM Manufacturing Index rose to 59.0 in October above the 56.8 expected
- The ISM Non-Manufacturing Index declined slightly to 57.1 in October but still reflecting expansion
- Hourly wage growth increased by its 6-month average of 2%
- Non-farm business productivity increased by an annualized 2.0% for the 3rd quarter, above the 1.5% rate anticipated
- Construction spending in September fell by 0.4%, below analyst’s expectations
- Factory orders in September dropped by 0.6%, also below expectations
- Initial jobless claims for the week ending November 1st came in at 278,000, slightly below the 285,000 projected
- The US trade deficit widened to $43 billion due to the stronger US dollar and a weakening global economy
- Manufacturing productivity increased by 3.2% for the 3rd quarter above the 2.5% expected
For the week, the S&P 500 rose by 0.7%, for a year-to-date return of 12%, including dividends.
Summary
IBD: Confirmed uptrend
GMI:6/6- Buy signal since market close of October 27, 2014
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Wishing you the best in investing,
Alan ([email protected])
Premium Members,
This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor premium member site and is available for download in the “Reports” section. Look for the report dated 11-07-14.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the link to the BCI YouTube Channel is:
http://www.youtube.com/user/BlueCollarInvestor
Since we are in Earnings Season, be sure to read Alan’s article, “Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:
https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season/
Best,
Barry and The BCI Team
Alan regards from Brazil,
As a premium member I have to thank you and your team for all the effort to put these reports to help us succeed.
I have a question about your premium report, what exactly do you mean in this part of the report:
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
Thank´s again and best regards,
Manuel
PS: in two months on USA market 6.2% of profit.
Manuel,
First, congratulations on your recent success…made my day.
When I am more bullish about the overall market I sell more out-of-the -moneny strikes which provides an opportunity for share appreciation in addition to the option premium. My bullish assessment this week means that I am selling twice as many out-of-the-money strikes as in-the-money strikes.
Keep up the good work.
Alan
Alan, this below is just a carry-on from last week.
– So for my previous 3rd question(MCU strategy) I was sort of meaning if the new 2nd stock then started declining – would there be a % guideline you have for any option buyback, or not bother? (as within the 2 remaining weeks or so anything can happen!)?
– And when thinking about this strategy today something I remember you said somewhere is that the return on the 2nd stock should be substantially higher than the cost to close, otherwise you won’t think of applying a MCU at all.
As an example if for instance initial return is 2%, cost to close is 0.50%, so unwind return = 1.50%.
If you then get 1% on new stock, then total profit will be 2.50%, but is this enough as it is only 0.50% past the original 2% return?
So in that case would you have some minimum % (past this 2%) that you need to actually see first or not?
That’s about all on the MCU I need to ask you at this point. Thanks
Adrian,
Once you own the 2nd stock, the exit strategy execution is exactly the same as if you purchased the stock at the beginning of the contract. Since we are mid-contract, more likely than not, the 10% guideline would apply unless the share appreciation took place very early in the contract.
2- I will generally look to sell an ITM strike on the 2nd position (as depicted in the Encyclopedia…see Figure 99, page 271) generating at least an additional 1% (over cost-to-close) return. The premium generated in the initial position is unrelated to this decision…that trade is already maxed out.
Alan
Alan,
Question. Been watching, buying , selling covered calls on PLUG !! This week sold the $5 CALL…price went to $5.30, and they got called away? Hmmmm. I thought shares got called away when the price went down?
Billy
Billy,
Your option is most likely to be exercised if share price moves above the strike price. In this case, the option holder can buy your shares for $5 and sell them @ market for $5.30. Most options are not exercised until the day after expiration Friday. PLUG is a security that has weekly options associated with it. One possible reason for exercise is that you sold a weekly and the price was above the strike at expiration which is automatic exercise.
Alan
Alan,
I bought your book “Exit strategies…” and I am glad I did. Your book is very explict , has lots of data and I learned a lot.
But I could not find exit stategies for coverd calls when the stock rallies.
Please help me with this one:
I sold a covered call on MU on 14 oct 14.The stock price was 27.58. The sold call was a 28 strike expiration 28 – nov- 14 option price 1.95 .My intention was to get income and not sell the stock.
On 22 oct the option price was 3.18 and the stock price was 32.3. I decided to buy back the sold option.
I tried you covered call calculator but I can not enable it to function.
Hope to get an answer from you.
Thanks,
Shelley
Hi Shelley,
This trade is a win-win for you. You made an excellent return and it will serve as a great learning experience. A few points:
1- There IS an exit strategy for this scenario but I didn’t develop it until after I published my 2nd book (“Exit Strategies…”). It is in my DVDS Programs and in The Complete Encyclopedia…:
https://www.thebluecollarinvestor.com/alan-ellmans-complete-encyclopedia-for-covered-call-writing-scover/
2- The Basic Ellman Calculator does not have a tab for this strategy (mid-contract unwind or MCU) but the Elite version of the calculator does. If you are a premium member, it is free in the “resources/downloads” section of the premium site. If not, it is for sale in the Blue Collar store.
3- Here is a link to an article I recently published about the strategy (more details in the Encyclopedia and both DVD programs):
https://www.thebluecollarinvestor.com/closing-our-entire-covered-call-position-when-share-price-rises-the-mid-contract-unwind-exit-strategy/
4- As I write this reply, MU is trading @ $33.03 so let’s see where you stand now:
Option debit: $3.18 – $1.95 = $1.23
Share credit: $33.03 – $27.58 = $5.45
Net credit: $5.45 – $1.23 = $4.22/$27.58 = 15.3% in a very short time frame…CONGRATS!
BTW: MU has weeklys so be careful of expiration dates when exceuting these trades.
Alan
Alan,
After buy back on drop, and a double not looking good,price slow staying down. Best to wait it out or apply another option position at lower level?
Covered call at lower level could result in call away or increased loss to buy back if volatility/price rise what action to take? Ie: don’t want additional position in shares but think opportunity from price drop/rebound till my existing positions can be “safer”.
Ted
Ted,
As time passes and theta is eroding the time value component of our premiums, delaying action could prohibit us from mitigating losses. I am more likely to take the approach of waiting for a share rebound in the first half of a contract but would favor rolling down or selling the shares in the 2nd half of a contract.
Share price can absolutely turn up late in the contract but (in my view) mitigating losses takes precedence during this time frame.
My approach reflects the conservative nature of how I trade.
Alan
Alan, I want to move on now to ask you probably some of the most important questions I have asked yet, about the use of put option protection. When the market went into a correction recently my papertrades all ended in a loss, and I had thought put options may have been better to have in place.
Therefore my questions about the put options use are:-
1. When thinking of buying a put option as protection within the contract month, what should be the latest time(or week) I should really have bought this by?- is it ever too late?
2. If the market has been known to sell-off in October from fund managers selling, then wouldn’t it be safer to always have put option protection for every October?
3. If the premium of a stock is greater than 4% for an ATM strike or any strike I choose, then can’t I buy a put option(as a collar trade), if because of ‘higher I.V ‘ there is now that concern about a price decline? (and yet will still give me an appropriate return)?
4. And if you sell ITM options when price is channelling s/ways, then do you still do so if the price is at or near the bottom of this price channel? (or is it always best to maybe sell options around the middle of each price-channel – or anywhere in it where perhaps you have more price advantage?)
I’m loving all this help you are giving me so far. Thanks
Adrian,
1- Generally, protective puts are purchased when the cc trade was initiated. This is called “married puts” When implemented we want to generate an option credit that meets our goals. This will be about half the return generated w/o the put.
2- In my view, there are way too many factors that influence our markets to make a general statement about Octobers. See the chart I created below from the past 3 Octobers. Of course, whenever your assessment is bearish you should take appropriate action.
3- I would base my trading style on fundamental, technical and common sense principles as opposed to the implied volatility of the underlying security.
4- The 4 parameters I use are exponential moving averages, MACD histogram, stochastic oscillator and volume. These are the indicators the BCI team uses when constructing our weekly stock reports. I encourage our members to use the indicators they are comfortable with…mine aren’t the only valuable tools…just the ones I’ve had the most success with.
CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG:
Alan